Federal Deposit Guarantee Could Result In Moral Hazard Says OECD

Post by Sharat on January 8, 2009 · Under Australian Economy, Featured Articles, banking · Comment 

A report issued by the Organisation for Economic Co-operation and Development (OECD) on the sovereign funding and deposit guarantees of eight member countries has warned that the Australian Federal Governments unlimited guarantee of all bank deposits could result in poor and reckless lending practices by banks.

Though the Federal Government has said that the guarantee on deposits is only valid for 3 years, the OECD report suggests that both depositors and lenders will now be under the belief that the Government will always rescue troubled financial institutions whatever the circumstance of their problems.

Australia is almost alone in its extension of sovereign guarantees for all corporate deposits, retail deposits and the wholesale funding obligations of Australian financial institutions on international credit and money markets.

The report written by the financial affairs division’s head administrator says that unlimited guarantees were a “remarkable feature” of the credit crisis and that they would erode the market discipline of lenders forcing governments to impose additional regulation.

The report went on to add that though depositor insurance and guarantees had become more substantial and this had increased the confidence of depositors and counterparties in the aftermath of the failure of Lehman Brothers an investment bank. Deposit guarantees also produced certain risks most notably that of moral hazard, where depositors do not punish banks who do not maintain prudent lending practices in the belief that governments will bail out troubled lenders.

The report suggests that the greater the extent of the guarantee, the greater the risk that there would be moral hazard and that is why in the past unlimited guarantees have rarely been given. The OECD has therefore said it is therefore vital that governments that have implemented such measures had credible exit strategies in place so that they may be able to withdraw their guarantees.

“Government guarantees can be withdrawn once times get better, that is once the crisis abates. However, once a government ventures down this road, there may be a general perception that a government guarantee will always be made available during a crisis situation.”

Guarantees Are Costly

The report cited Japan, which had its own domestic banking crisis back in the 90’s and had implemented an unlimited deposit guarantee in order to stabilise what could have then been a run on the entire banking system, and had found it difficult to roll back the measure. A process which took the country several years to achieve.

The OECD said the guarantees had given governments time to strengthen their banking systems. “However, if governments wait for all deficiencies in an economy or financial system to be addressed or the system to be reformed, blanket guarantees could become entrenched.”

The OECD stressed that unlimited guarantees could carry an extremely high cost, particularly in small nations with well-developed banking systems such as Australia where total banking assets are more than double GDP.

It said governments offering guarantees needed to be explicit about how they would be paid for if called upon, for the guarantees to be credible. It went on to add that in the event of widespread bank failures, financial markets would make it very difficult for countries to raise the funds needed to make good on their guarantees.

Although many nations strengthened their bank deposit guarantees in response to the credit crisis and financial crisis brought about by the collapse of Lehman Brothers and the nationalisation of AIG within days of each event, the OECD noted that Canada, Italy, France and Japan had left their deposit insurance unchanged.

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